Obama's 'Nuclear Option' on China's Yuan

As a candidate, Barack Obama said he would "insist that China stop manipulating its currency because it's not fair to American manufacturers." As president, Mr. Obama could have fulfilled that campaign pledge well before his visit to China this week.

But swaying China's yuan is easier said than done.

For years, Bush officials accused China of "manipulating" its currency by keeping the value of the yuan down against the dollar. They made little progress.

A cheap yuan lowers the cost of Chinese goods in the United States, while raising the price of US goods in China. In short, it's a major cause of the huge US trade deficit with China.

China desires to keep the yuan pegged to the US dollar at a low value because it believes this is the best way to boost Chinese manufacturing and create millions of job. Such domestic concerns explain why Beijing largely rebuffed efforts by the Bush administration, and now the Obama administration, to raise the value of its currency.

How could Obama break the impasse?

The first step is to get clarity on the problem.

First, there is no issue of "manipulation" with China's currency. The Chinese government is not sneaking around in the middle of the night trying to influence currency prices. China has an official exchange rate that puts the value of its currency well below the market exchange rate. This official exchange rate is widely publicized. We don't have to catch them acting improperly in the dark; anyone can just look in the paper or call the Chinese embassy to ask what the exchange rate target is.

Second, the US doesn't have to "pressure" China to boost the yuan. Contrary to what you may have read in the paper, Washington is not helpless in this story.

Just as China can set a value of its currency against the dollar, the US government can set a value of the dollar against the yuan. The Chinese government currently supports an exchange rate at which the dollar can buy 6.8 yuan. This high value of the dollar makes US goods uncompetitive relative to China's. To make US goods more competitive, the US could adopt a policy through which it will sell dollars at a much lower price, say 4.5 yuan.

The difference in exchange rates would provide an enormous incentive for Chinese businesses and individuals to exchange their yuan at the Treasury rate rather than the official Chinese rate. While this may violate Chinese law, the enormous potential profits would make the law difficult to enforce. In a relatively short period of time, the US exchange rate is likely to become the effective market exchange rate.

Of course, this situation of warring exchange rates would lead to a period of instability and unnecessary hostility between the two countries. However, it would send an important signal that the US government is in control of its dollar destiny: Washington has the ability any time it chooses to push the dollar down to a more reasonable level against the yuan.

Such a bold move carries a price. Short-term negatives of a lower-valued dollar include higher import prices, which translates to higher inflation and somewhat lower living standards. Politically, it may be difficult for Washington to intentionally overpay for China's currency at a time of high unemployment, even if the goal is to boost jobs at home.

The financial industry might oppose this step since a strong dollar makes it a more important actor in world capital markets. The industry also opposes anything that could lead to more inflation, even if this is a necessary step toward rebuilding America's manufacturing sector.

If the Obama administration was prepared to accept the short-term consequences and confront the financial industry, then it could let the Chinese government know that it was serious in wanting a lower value for the dollar against the yuan. It could even specify a date at which it was prepared to start offering to sell dollars at a lower price than the official Chinese exchange rate.

This would presumably set in motion a process of negotiation whereby China would agree to raise the value of its currency over a period of time against the dollar. Eventually, this would bring our trade deficit down to a manageable level. However, the key to getting to such a point is understanding that the United States is not helpless in determining the value of its own currency.
Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy. He also has a blog on the American Prospect, "Beat the Press," where he discusses the media's coverage of economic issues.